Sunday, April 6, 2008

The U.S. Consumer Retrenches

This is from another list by a Goldman Sachs economist. The stimulus package may help a bit as consumers but it will take time to kick in probably. Note that this article predicts housing price declines to bottom out in the middle of next year! The losses in the mortage sector are staggering.

US Views: The Consumer Retrenches

1. The US economy has evolved along the lines of the recession template welaid out in early January. First, the most important labor marketindicators -- nonfarm payrolls, the unemployment rate, and the joblessclaims data -- are now all deteriorating at a clearly recessionary pace.Second, the news on consumption has worsened substantially in recentweeks, with a sharp deterioration in auto sales and auto loandelinquencies (now at the highest level in 30+ years) and poor anecdotalsabout March retail sales. Third, taken together the monthly measures ofeconomic activity that are used to officially "date" business cycles -- payrolls, income, business sales, industrial production, and monthlyGDP -- are also looking more consistent with recession, at least if weallow for the normal tendency of economic data to be revised downward atthis stage of the cycle.

2. We still think that the pace of decline in real GDP will be relativelymodest. This is partly because of structural changes in inventory andpayroll management, partly because of the weak dollar and the improvementin foreign trade, and partly because fiscal and monetary policy havealready responded aggressively to the downturn. The fiscal boost, inparticular, is likely to lift consumer spending in the second half of2008, and an add-on package is not out of the question if the jobs picturecontinues to deteriorate (some Democrats are already calling for this).This is why he have held onto our forecast that the Federal Open MarketCommittee will stop easing monetary policy after one more 25bp cut onApril 30. Cuts in subsequent months are unlikely because the committeewill want to assess the effects of the tax rebates before moving further.Moreover, Fed officials are hopeful that the financial market improvementover the past few weeks will reduce the pressure on them to ease further.

3. But the economy is likely to look weak until house prices bottom, whichwe don't expect until the second half of 2009. The reason is simple supplyvs. demand. Although home inventories reported by builders and realtorshave started to decline, broader measures that include foreclosed homesstill seem to be rising. Until the excess supply shrinks substantially,home prices are likely to keep falling; we are looking for furtherdeclines totaling 10% in 2008 and another 5% in 2009.

4. As we have argued before, these declines are likely to result in creditlosses totaling $500 billion in residential mortgages alone, and over $1trillion including other credits. Of this total, we estimate that roughly$460 billion (equivalent to about $300 billion on an after-tax basis) willfall on leveraged US financial institutions. So far, they have onlyannounced about $120 billion of this total. They are likely to respond tofurther losses by continuing to shrink their balance sheets. Using themodel developed in our Leveraged Losses paper (with Greenlaw, Kashyap, andShin), we estimate that these losses imply about a 2-percentage-point hitto real GDP growth, before considering multiplier effects. Even after theformal recession ends, this retrenchment is likely to weigh on theeconomy, and this is one reason why we expect the unemployment rate toreach 6-1/2% by the end of 2009.

5. As long as the unemployment rate is still rising and house prices arestill falling, the Fed will not raise rates. So short-term interest rateswill need to stay low for an extended period of time, and renewed cuts inlate 2008 or 2009 are much more likely than early interest rate hikes.This is not necessarily an "investable" view at this point -- if the datado get a bit better in the wake of the fiscal stimulus, the marketscontinue to relax about systemic risk, and the Fed is stingy withnear-term rate cuts, a further modest selloff in the Eurodollar curvecontracts is quite possible. But Eurodollar curve flatteners could becomeattractive soon.